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Is Southwest Airlines Stock a Buy? Warren Buffett Thinks So.

Motley Fool Staff, The Motley Fool

Southwest Airlines (NYSE: LUV) has cut its guidance twice in the last two months, but the airline achieved a record adjusted profit and record free cash flow in 2018. The company has also affirmed that demand trends for the second quarter look strong, pointing to the potential for a quick return to profit growth.

Meanwhile, Southwest Airlines stock trades for just 10 times free cash flow: a remarkably low valuation for a company that consistently posts strong margins while growing steadily.

So it's no wonder that Warren Buffett has invested in Southwest Airlines. And recent rumors suggest that Buffett sees Southwest as a possible acquisition target for Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B). Industry Focus: Energy host Nick Sciple and guest Adam Levine-Weinberg review the case for owning Southwest Airlines stock and assess the likelihood of a takeover by Berkshire Hathaway.

A full transcript follows the video.

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This video was recorded on April 4, 2019.

Nick Sciple: As we look at Southwest's stock today, is it a buy today? It just came off one of its best years ever when it came to many of its operating metrics, but there is some near-term uncertainty, as we laid out in the front half of the show with the 737 Max. As you look at this stock today, do you think it's a buy? Or should investors wait and see?

Adam Levine-Weinberg: I would say that Southwest Airlines does look like a good buy right now. For one thing, the stock is extremely cheap. Southwest Airlines stock trades for about 10 times its 2018 free cash flow, which is really quite low considering how strong its balance sheet is, how significant its growth opportunities are, and how high its profit margin is. It's really a strong, stable, and growing company. Businesses like that usually trade for a premium. Whereas Southwest Airlines is really trading at quite a big discount relative to the rest of the market.

There obviously have been some headwinds, but there's also a good amount of reason to be hopeful that those headwinds are going to fade even within just a few months. For one thing, the maintenance-related cancellations, which I mentioned earlier, related to a dispute with the maintenance personnel. Southwest Airlines actually recently reached a tentative agreement for new contract with its mechanics' union. That's really good news. Obviously, it hasn't been ratified in the membership yet. But there's a pretty good reason to hope that it will be. That should settle one of the biggest labor disputes that's been going on at Southwest Airlines in recent years. Hopefully get the carrier back to what's been more typical over the years of having pretty good labor relations.

The second thing, obviously, is the 737 Max. Boeing has proposed its software fix. It's done a test flight now. It's still refining the exact changes, but it's probably going to be submitting that fix to the FAA within the next few weeks. That gives a pretty good chance that by June or July, perhaps the 737 Max will be back in the air. Once those headwinds are gone, Southwest Airlines does have a good chance to return to a pretty significant profit growth.

I should mention that part of Southwest's guidance update that came out in late March said that while the first quarter was going worse than expected, it still was seeing very strong bookings and was expecting high unit revenue growth in the second quarter. So it certainly seems like customers haven't been chased away by fear about the 737 Max at Southwest Airlines.

Sciple: Sure. When we're talking about whether Southwest is a buy, I would hate not to mention the rumors that Warren Buffett and Berkshire may be exploring buying an airline. Southwest has been part of those rumors. In late February, the shares got a little bit of a pop on rumors that Berkshire and Mr. Buffett were exploring buying the airline. Again, the business is coming off one of its greatest years. There's some near-term uncertainty. We have the Oracle of Omaha taking a close look at buying the business. I think it's something that belongs on folks' radar.

When you look at this Berkshire speculation, Adam, what are your thoughts on it? Do you have any thoughts about the rumors circling around with regard to Southwest and Berkshire?

Levine-Weinberg: Yeah, it's definitely an interesting rumor. It's definitely an interesting possibility because, obviously, Berkshire Hathaway has gotten involved in the transportation sector before. Buffett, of course, for many, many years hated the airlines. He had a bad investment in U.S. Air back in the 1990s. After that, he swore off investing in airlines for decades. But in the last couple of years, he's changed his mind again. The main reason is that there's a lot less competition. It's more of a rational industry structure for the airlines now. There's really four big airlines and then a few smaller ones competing in the United States. There were at least a dozen major airlines all in a very cutthroat competitive situation if you look back about 20 years. For that reason, I do think there's reason for Buffett to be interested in Southwest Airlines. He's been very clear in the past year or two that he would like to make a big acquisition at Berkshire Hathaway, and it's just a matter of first finding the right fit, and second finding a business that's not horribly overpriced. A lot of the stocks he's looking at are quite expensive just because the market has done so well over the last few years.

Southwest Airlines, as I mentioned, it's trading for only 10X free cash flow. It's really quite inexpensive. And it's a very solid business. While Buffett has invested in several different airlines in recent years, Southwest stands out has the highest margins by a pretty significant margin, [laughs] as it were. It has an operating margin of about 15% in the last two years, which is very good. It also already has a strong balance sheet. Buffett wouldn't have to take on a lot of debt to buy the company. And it's got a strong and entrenched management team that has been there for more than a decade. They know how to run the business. They've shown an ability to respond through events like the Great Recession, some of the oil price spikes we've had in the last 10, 15 years. There's obviously no guarantee that Buffett will go ahead and buy the company for Berkshire Hathaway, but it's not a bad fit.

Sciple: Yeah, definitely a story we're going to continue watching for Southwest, along with the other stories we mentioned today.

Adam Levine-Weinberg owns shares of Southwest Airlines. Nick Sciple has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares) and Southwest Airlines. The Motley Fool has a disclosure policy.